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Is It Good to Invest in Small Cap Funds?

In Finance
August 13, 2020
Small Cap Funds

Small-cap funds are one of the best performing investment options for most individuals today. Regardless, one can benefit from such an investing avenue only if they know how to make the most of its features and align the same in their favour.

Consequently, potential investors need to become familiar with the fundamentals of small cap stocks and funds to gauge their performance and proficiency in terms of risks and reward.

What are Small Cap Funds?

Small cap stocks are equity funds that invest in the shares of companies with a lower market capitalization than many mid or high-cap enterprises. In other words, such funds invest in companies listed after the top 250 companies in the stock exchange as per full market capitalization. Typically, the capitalization of such companies is less than Rs. 500 Crore. Over the years, small-cap funds have gained the attention of investors owing to their capability to generate high returns. However, to generate better earnings from their investment, individuals should become familiar with the features that accompany these funds.

Thus, your answer to ‘Is small cap a good investment?’ depends on several factors.

Features of Small Cap Funds

Typically, most small cap stocks come with features listed below –

  1. Cost of investment: In addition to the cost of acquiring these funds, one has to pay an Expense Ratio to manage the funds annually. Such an annual fee comes with an upper limit of 2.5% of the average AUM.
  2. Volatility: Market fluctuations tend to play a vital role in influencing the NAV of small cap stocks. As a result, these funds often tend to perform exceptionally well in the bullish market but may under perform significantly during the bearish phase.
  3. Associated risks: Being dependent on the market forces, the small-cap funds come with a significantly high risk factor. Resultantly, they take time to recover in a recessionary market and may generate underwhelming returns or incur loss during the same.
  4. Returns: Small-caps are often categorized as a multi-bagger, owing to their potential to generate over 100% returns on investments. They can prove immensely useful for investors who wish to generate higher earnings to meet their long-term financial goals – like planning a child’s higher education, purchasing a house, paying off existing debt, building a retirement corpus, etc.
  5. Investment horizon: Generally, small cap funds perform well in the long-run. Financial experts often recommended small-cap investors to stay invested for a period of at least 7 to 10 years to generate returns as expected.
  6. Taxation: The earnings made on redeeming small cap fund units that were held for a year are treated as short-term capital gains or STCG. As per ITA, all STCGs are subject to taxation at the rate of 15%. On the other hand, earnings on small-cap funds units held for over a year are subject to tax at the rate of 10% without indexation benefits as they are treated as long-term capital gains or LTCG.

Are Small-Cap Funds a Good Investment Option?

To determine – Is small cap a good investment or not, individuals must gauge the effectiveness of the features and benefits that accompany such funds.

  • High growth potential

Unlike large-cap companies, small-cap companies reflect a better and more organic growth rate. As a result, it helps them to increase their market capitalisation over time and further strengthens their growth potential. Resultantly, investors who intend to witness the growth of their investment portfolio may find favourable outcomes by parking their money in small-cap funds. Also, being high-yielding funds, investment options like Principal Small Cap Fund can prove to be a useful addition to one’s investment portfolio.

  • Fairly-priced stocks

Certain limitations bind the extent to which institutional investors can park their money in small-cap funds. It works in favour of small investors and further helps them to avail small cap stocks at fair prices. Additionally, with some evaluation and thorough market research, investors can scout under-priced shares of small-cap companies that show promising growth prospects. This way, they can lay hands on the best performing shares at nominal prices.

  • Diversification

Also, by incorporating funds like Union Small Cap Fund into their investment portfolio, investors can balance their risk-reward aspect successfully. In addition to low-yielding and low-risk investment options, small-cap funds will help them to diversify their portfolio and lower the overall risk of the portfolio significantly.

Regardless, to avail the answer to – “Should I invest in small cap mutual funds?”individuals must factor in their limitations as an investor.

Who Should Invest in Small Cap Mutual Funds?

Typically, investors who are better at weathering higher risks can find it more suitable to invest in small cap funds. Other than that, those who are patient enough to keep their money invested for a more extended period and have an eye for quality stocks over cheap ones are more likely to benefit from investing in this category of mutual funds.

Nonetheless, investors with high-risk appetite and patient temperament should also adopt some sound strategies to make the most of investing in small-cap funds.

For instance, they should incorporate these strategies, to begin with –

  1. Look for the composition of small cap mutual funds

Investors should be cautious when it comes to choosing a particular small cap stock. They should look for funds that have a track of performing better than the benchmark and most other small cap funds. It will help to generate higher returns at relatively low risk. Other than that, they should also pick a suitable fund size and route their investment according to the market situation.

  1. Factor in your investment goals

Investors must weigh in their individual financial goals before investing in this category of funds. It must be noted that small cap funds are not ideal for generating aggressive returns in the short-term. Hence, they are not suitable for meeting short-term financial goals.

  1. Adjust the cost of investment

To assess the impact of the cost of investing in small-cap equity funds, investors should check the net returns they are likely to be left with post expense. It will help them make an informed decision when it comes to shortlisting more profitable funds with investment and financial information

  1. Pick an extended investment horizon

As discussed, small cap mutual funds prove most effective in the long run, which is why investors should always pick long investment tenure, preferably more than 7 years. It will protect returns from being eroded and will help to meet long-term financial goals more effectively.

Should You Invest in Small Cap Funds Now?

Thoughts pertaining to Whether it is good to invest in small cap funds now is rampant among investors. As per current evaluations, market experts believe that small-cap funds may perform better than most large-cap funds.

Nonetheless, financial advisors recommend to spread out investments and avoid investing in lump sums. It is also advisable for investors to route their investment in this category via SIPs or STP for the next couple of years.

Irrespective, investors must factor in the size of funds and their capability to manage its requirements in terms of flow. It will help them to manage their investment portfolio better and cushion associated risks proficiently. In turn, it will help them ascertain ifit is good to invest in small cap funds or not.